Tesco plc – Does the “New Reality” Checkout?

It’s difficult to do a post on Tesco because what can I say that hasn’t already been said? Seems unlikely I can add any insight to the cumulative wisdom of the 41 sell side and umpteen buy-side analysts who cover the stock full time? On that basis this is much more qualitative than quantitative.

I think Tesco is a “time horizon arbitrage” long at this stage. The old adage is that profit warnings come in threes and so far we’ve only had one so there may be more bad news to come. Because of this, most of the sell side has taken a big step back and will avoid the stock for a few quarters until we have “more clarity” (and the price has moved one way or the other by 20%). For the buyside, there is a decent amount of risk in being seen to have “topped up” if it falls again because the knives are out for the company right now. For investors who can look out a year or two then I think this is an interesting opportunity which on that kind of horizon, with the help of the dividend, will handily beat the return on the FTSE 100 or on cash.

Description

Tesco PLC is an international retailer. The principal activity of the Company is retailing and associated activities in the United Kingdom, China, the Czech Republic, Hungary, the Republic of Ireland, India, Japan, Malaysia, Poland, Slovakia, South Korea, Thailand, Turkey and the United States. It is the market leader in the UK, Thailand and South Korea. The Company also provides retail banking and insurance services through its subsidiary Tesco Bank. Its online businesses include online grocery and Tesco Direct.

Market Cap (£) £26bn

Price 325p

P/E 10x

Dividend Yield 4.5%

Dividend Cover 2.2

Piotroski Score 8

Investment Case Summary

Quality

Tesco is twice the size of its UK peers. Size and scale matter in this business, look at Wal-Mart’s operational performance. Tesco has a long history of operational excellence, is a market leader and has a strong, investment grade quality balance sheet with expansionary spending mostly behind them. Tesco is one of few businesses that benefits from a negative working capital cycle, they do not have to pay suppliers for goods until after they have already sold them and received payment from customers.

Value

The shares have been significantly de-rated thanks to the company’s first ever profit warning in January. The sell side has become increasingly focused on the metric of LFL sales in the UK business which has been struggling and will be difficult to turn around quickly as operating momentum in grocery retailing is not easily won.

Management have announced they will be rebasing UK profitability by investing in the “customer offer” – in price and in better staffing. They confess they have probably “over-earned” in the UK in the last few years by running the business too lean. An example of this is that the number of employees per 1,000 sq feet of store has declined from 74 to 61 since 2004.

The value opportunity arises because this myopic focus overlooks that there are other parts of the business at FCF inflection points or showing good value. Operationally the business is struggling but we have to remember its history of delivery – for the 2000’s Tesco grew earnings at a compound 11.5% per annum. This isn’t going to happen going forward but this is at least a GDP + inflation growth business.

Additionally, it is interesting to note that three directors and Berkshire Hathaway have purchased shares since the price decline in mid January. Warren Buffett now owns 5% of the company.

Growth

Tesco has a long list of potentially value creating options at its fingertips. It has promised that Fresh & Easy will either start performing or close in the next year or so. At the moment this division loses around £100m a year. The closure of the Japanese business shows a more ruthless approach from management regarding non-core operations – they should either deliver or be closed from now on. The businesses in Korea and Thailand have now achieved critical mass, contributing 10% and 5% of profits respectively. Asian operations are expected to produce almost £700m of profits in 2012.

Tesco Direct provides the online shopping element of TSCO, groceries and non-food. Interestingly online sales are done at an 8% margin rather than a 6% margin for the business as a whole so this businesses growth should help going forward. However, the true look through margin differential may actually be less impressive given that many of the costs of the online business are borne by the normal stores where “pickers” collect the shopping before it is sent out to customers. This will likely be addressed overtime by moving online business to centralised “dark stores” and distribution centres where there are no customers only staff focused on fulfilling online orders. The benefit of this is that the stores can be built on much less expensive real estate and do not have to be quite as aesthetic.

Although non-food Tesco Direct – which sells home, clothing and electronics etc is currently a weak part of the business because the UK economy is weak and because it takes up a lot of expensive floor space in the hypermarkets I do not believe this shall always be so. Looking 5 years out I think the UK High Street is doomed, sales are going to move online to Amazon/Tesco.com/SportsDirect.com/ASOS and the incumbents like Comet/Argos/Dixons/Matalan are going to start dropping like flies. They cannot offer the same range of products and they can’t sell it at the same margin due to their expensive square footage. Over time we might see the Tesco Direct floorspace in stores become like a shop window for the most popular deals from the 100,000+ products available online.

The services division offers a few “free options” for growth in things like Tesco Telecom which they aim to contribute £150m of profits by 2013 or Dunnhumby which owns consumer information making £80m per annum and finally the insurance business where Tesco are actually the 6th largest motor insurance business in the UK. All of these businesses are materially valuable and robust but they are a little lost within the context of the giant conglomerate.

Business & Management

Strengths

Through “Clubcard” Tesco knows its customer’s shopping habits better than any of its peers. Historically, Tesco’s retail execution has been very strong with its multi-format flexibility allowing it to closely align store space with its target markets and target customers.

Weaknesses

Management have no credibility yet due to short track record and a failure to deliver on initiatives. It seems the new CEO may have been thrown a “hospital pass” upon taking the job. There are worries that its decades of success have left Tesco a sprawling conglomerate suffering from “mission creep” and perhaps a little complacency.

The highest P/E multiples are placed on focused specialists rather than generalists. For example, management must ask why they are in the garden centre business when it doesn’t move the needle and just provides a distraction.

The dramatic lowering of profit expectations has allowed the doubters of Tesco to jump on the bandwagon citing that the business has been run too hard for efficiency, it has become complacent, there are cultural issues and that their marketing effort has been weak.

Margins are going to be a bit weaker in the UK business due to the “over-earning” issues from the past. Tesco do however have the best margins in the sector so a move back towards its peers is now getting priced into the market.

Opportunities in Tesco Bank

Hypermarkets may be ex-growth but Tesco has many opportunities in the smaller stores like Extra or in the roll out of the Services division, particularly Tesco Bank which is just rolling out its mortgage offering in the UK. I think Tesco has a very large opportunity here to steal basic banking/savings/deposit business from the incumbent major UK banks. RBS, Lloyds and to a lesser extent Barclays have permanently impaired their reputation and their relationships with their customers. Tesco may have a reputation as a big, nasty profit sucking corporation but not to anything like the same degree as the banks. For banking, TSCO’s ubiquity and brand recognition will help. The placing of “branches” in the stores will save money because there is no incremental high street real estate required and furthermore they are guaranteed footfall from the stores.

At the moment Tesco Bank is a negligible part of the business (circa £150m of profit) but in 10 years time it’s possible that they will have considerable market share. Analysts have been quite explicit that there is no risk at this stage that the bank will jeopardise the broader Tesco balance sheet with undue financial risks.

Opportunities in Real Estate

The Tesco freehold real estate portfolio was valued as of the last annual report at roughly £32 billion. I think the sell side is almost completely ignoring this asset backing because of their focus on the income statement and the fact its inherent value is a slow burning process. The property assets provide a degree of inflation protection too.

The stated aim of selling down the real estate portfolio over time to realise imbedded profits, whilst implementing the new commitment to limiting the capex on expanded on store expansions in the UK will materially shift FCF in a positive direction. UK Capex was £2.6bn in 2008 and some analysts estimate this new rationalization could take this down to £1.3bn by 2014 which could add 5% to the FCF yield.

Tesco has been selling down real estate assets at a rate of around £1bn a year realising £200-300m of profit – this could be ramped up going forward and there are further considerations of a Thai Tesco REIT or other such OpCo/PropCo options.Threats

Consumer sentiment towards “big business” is poor, exemplified by campaigns from high profile TV chefs amongst other things. This trend has yet to translate towards sales moving away from the Big 4 however – this seems unlikely due to their one stop, price competitive position. Depending on one’s macro view, Tesco’s non-food exposure is a threat relative to its peers. Austerity induced fiscal drags and fuel price inflation which takes significant wallet share will be a secular headwind for consumer spending going forward.

There is an unfavourable supply/demand dynamic in UK Food retail currently. Sales growth is slow and slowing but industry floor space is still expanding, this points towards some leaner years ahead for profits.

What Needs Work?

Marketing has been poor for years and there is a less clear brand message than MRW and SBRY in particular. There is also less impetus in the own brand products than the peers and it seems to be coasting on the fact it is all things to all people. There is no attempt via product or store architecture to differentiate or target particular customers. A store in a high end area will appear almost identical to a store in a poorer post code. Stores remain industrial and bland feeling with “character” being sacrificed for lean productivity.

Tesco has a very attractive final salary pension scheme relative to peers and it is a major draw or retainer for lots of Tesco staff. It seems like the profit warning will be a good opportunity for management to take steps to “rationalise” or “right-size” this pension promise that they really no longer can afford.

Competitive Position

Supplier Power

The UK food retail market is highly consolidated, has high levels of property ownership, national pricing and relatively flexible labour laws. Tesco’s scale and buying power means it exerts considerable pressure over its suppliers.
The four big players in the UK – TSCO, MRW, SBRY and ASDA are pretty rational. In 2000 they had a combined 55% share of a £50bn market, now they have a 70% share of an almost £100bn UK food market. Tesco’s share is largest at around 30% of the market. All are listed and all have the same time horizons. It seems unlikely that a price war is anyone’s best way to take share from anyone else.

Food retail in the UK is a very competitive business and continuing operating weakness in the UK does not bode well for Tesco’s market share. As of today however they are still very dominant.

UK Food Retail has significant barriers to entry due to the enormous economies of scale in the incumbent market leaders. There is also a degree of loyalty amongst consumers who tend to change where they shop slowly due to habitual behaviour.

Customer Power

Tesco’s market dominance has allowed it to permeate many aspects of its customer’s lives but they do retain the ability to “vote with their feet”. It would seem that customer’s habits are somewhat sticky and often shop in the supermarket closest to them.

Management Incentivisation

Compensation was changed to focus on ROCE since 2006 and the target is from today’s 12.9% to 14.6% by 2014.

This focus on ROCE will only hasten the team to deliver on or close Fresh & Easy like they did in Japan. There should be some natural improvement in ROCE as the project pipeline of stores roll off and open and are not replaced with the same intensity of development.

Management will receive bonuses of between 225-300% of salary if they can achieve compound EPS growth of 12% over the three years to 2015.

Conclusion

The investment case for Tesco remains the same as it was a year ago, the major capex of rapid UK store and overseas expansion is largely behind us – critical mass has been achieved. This leaves Tesco now trades two standard deviations below its long term P/E multiple.

We expect management to start to focus on shareholder returns and customer satisfaction. There are a number of relatively easy to implement options that can be deployed to start to bring the intrinsic value of the business to the market’s attention. Warren Buffett and the Directors of this business know it well and they have been adding to their already sizable holdings. The share price decline from 400p to 320p presents a fantastic opportunity for long term investors to pick up a consistent, market leading, asset backed franchise at a discount to the value of its bricks and mortar.

A friend of mine and their partner work at Tesco and so I sought their opinion on a number of the criticisms recently raised by analysts and their thoughts on the steps management would be taking to address the issues. I attach below their comments verbatim.

What I find interesting is that these problems were very visible on the ground but yet left unaddressed. However, one might say that at least now the top and bottom of the organisation both know where they were going wrong and are headed in the same direction.“Alas I have seen changes in the past 2 years. I’d say particularly in the past year. Staff who leave are not replaced or replaced with someone with fewer hours or a lower wage. Particular departments run on skeleton staff or no staff at all. They rob Peter to pay Paul. All this is amounting to a growing unrest amongst staff, low morale, less energy. Personally, I don’t enjoy my job 70% of the time, mainly because I don’t have the time or resources to fulfill customer’s needs. New staff are not being offered the same Sunday rate as current staff (150%). New service desk staff are not awarded a premium, they are offered the same rate as a checkout/shelf stacker.
The Big Price Drop was introduced by closing all stores overnight in order to change prices/promo material. Customers expected massive bargains and instead received goods at the same prices they were a few weeks earlier – it’s nuts! I’m not sure how well my store relates to the mean but my outlook is pretty bleak. (Name) would love to move elsewhere but I still think he’s in one of the safest jobs he could have currently.”“Customers believe there are many things done to deliberately trick them into buying goods at a higher price than they believe. Shelf edged promos and promo labels are often a bit misleading. Promos “From £1” merchandising posters are next to products where only about 25% of the goods are £1.

I could go on listing the negatives but I think it’s important to mention the positives. Unfortunately, many customers are unaware of Clubcard points and their rewards. Some customers, including myself, revel in the scheme whereby Tesco reward loyalty by issuing money saving vouchers which may be used against grocery shopping or traded for 4x their value to spend elsewhere. Many customers do appreciate this but it doesn’t deal with the immediate shopping experience. I reckon change is needed whereby honesty is key. Customers want to be able to do their shopping quickly and efficiently, they want to glance at the price and know it’s what they’ll pay at the checkout.”

“In stores you have general assistants, team leaders, department managers, senior managers, deputy managers and store managers. I think team leaders are surplus to requirements, except at checkouts. Dept managers vary widely in competence. It seems to be a case of who your chums are and not what you know that sees you through to management – at least this is the only way I can explain what I have seen. Deputy Managers are like floor managers and Senior Managers, of which there are 3 or 4 in my store, are not so hands on, but its variable.
Beyond that there are directors who look after groups of stores across the country. There are also floating managers who take on roles out with their job description/special projects to be rolled out to different stores.”

“When it comes to produce items, I wouldn’t buy fresh fruit or veg from ASDA (Wal-Mart subsidiary) because I don’t believe it’s as fresh. I get all mine straight from the fruit market. Tesco is a mixed bag. I prefer Tesco overall. If Marks & Spencers was larger and less expensive it would win hands down. As for the competition, I am not a huge fan of ASDA as I just couldn’t do a full shop there, it’s too basic/low end. Sainsburys seems of a very similar quality to Tesco but is overpriced. I’ve never liked Morrisons as I believe it lacks variety.”

Hi
Aren’t you double counting the property here?
If you assume they sell the property for say 30bn, and the new owner is getting (say) and 8% yield then UK profits go from 2.4bn to 0 (ok a bit higher because its tax deductible)

My comments: over the last 10 years the operating margin has been hovering close to the -2% (cumulative) threshold beyond which I would say that revenue is being bought with erosion of margin. Further, the ROE is running at -2% cumulative. From the annual report the ratio of the remuneration of the top 3 directors is about 25% of the wage bill – a bit high for me. Debt has been over 50% of equity for the last three years.
Regards
Colin Farrier

Don’t understand this comment. From the report the total wage bill is £5467m for the 492,714 people employed (including directors). The top 3 directors seem to get about £10m between them. Which gives their earnings as less than 0.2% of wage bill. The rest of the article is spot on especially the appendix!

Good article and I agree in general. However I would substract the present value of operating leases carried off balance-sheet of about 8bn. This yields a value of about 4,5 pounds per share which sounds fine to me.

The current financials of TESCO justifies itself (very well explained in the post here). As always, it is the future that matters. The only condition under which I would prefer to buy TESCO is to think of it as a Bond with a 10% earnings yield that will grow at some rate in the future (It grew double digit in the last ten years)

The thing that bother me about TESCO (and the retailer channel in general) is

What is the long term threat from a e-commerce only model like Amazon? (On non-food and some food products) Will TESCO online be able to compete with AMZN long term? I do not know how much of a threat is AMZN is in UK (as compared to the US) How does the Grocery differ from other items that AMZN will not be able to penetrate the market?

It would be great if you can drop a few lines to share your insights. Hope to return the favor on a rainy day.

Amazon is massive and growing in the UK just like the US. They are killing many retailers here but it is mostly our equivalents to Best Buy rather than our fresh food retailers.

I think Amazon shouldn’t bother to enter the fresh food business (have they actually done this in the US?) there are many issues of supply chain/refridgeration/stock turnover that you just don’t have to deal with when you are selling books/dvds/electronic goods.
In fact I think there is a chance that Tesco Direct can take business from Amazon as people will use Tesco Direct next to their Tesco grocery delivery. It’s not going to put Amazon out of business or anything but it might be a nice cross selling oppportunity for Tesco.

Great analysis, well researched and written articles. I discovered your articles after looking for like minded investors. I too had analysed and purchased British empire, and tesco. Being a qualified accountant, I always start with a balance sheet approach however I still place a lot of emphasis on my FV model but with the knowledge of the impact of the growth rate on final valuation. This is where the art meets the science of investing! I will watch your future posts with interest. You deserve to do well given your clear dedication to wise capital management.

Great analysis but you are definitely double counting the property value here. The problem is that the `trading profit` or EBIT disclosed by the management already includes rental income which is sizable compared to the overall EBIT.

The best case scenario would be a complete separation of the real estate portfolio through some form of tax free REIT spin-off which would necessarily involve a massive lease-back program that would dramatically reduce earnings potential in both the UK and Asia retail operations so the stand-alone earnings power of the retail arm is actually much less than the numbers advertised. This is the only way the real estate value can be fully realized which given the quality of the management is extremely unlikely.

What will likely be the case is that the company will continue to `plan`the sale of real estate on an annual basis the same way as before, so almost without consideration for valuation purely for the purpose of keeping property profits stable. Now this is plain bad management and not nearly as ideal as a larger spin off because the real estate management business doesn`t earn any returns near the cost of capital. It still creates some value anyhow so I think the base case assumption should be that the real estate value must take a rather sizable haircut. I agree that the business is undervalued but not nearly to the degree that you modelled out.